X Company is using a fully depreciated machine having a current market

| February 25, 2017

Question
X Company is using a fully depreciated machine having a current market value of Rs 20,000. The salvage value of the machine eight years from now would be zero. The company is considering replacing this machine by a new one costing Rs 102,500, and having an estimated salvage value of
Rs 12,500. With the use of the new machine, annual sales are expected to increase from Rs 80,000 to Rs 92,500. Operating efficiencies with the new machine will save Rs 12,500 per year as operating expenses. Depreciation will be charged on written down basis at 25 per cent. The cost of capital is 11 per cent. The new machine has a 8-year life and the company’s taxation rate is 35 per cent. Assume that book profit or loss from the sale of the asset is taxable at corporate tax rate. Should the company replace the old machine? Show calculations on incremental cash flow basis. How would your decision be affected if another new machine is available at a cost of Rs 175,000 with a salvage value of Rs 25,000. The machine is expected to increase sales by Rs 12,500 a year and save Rs 30,000 of operating expenses annually over its 8-year life.

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